Venture Returns are Horrible, and It's the Fault of...the Investors?

If there is one thing investors in venture capital funds are good at, it's wimping out. Limited partners in venture funds, or LPs, have historically sucked at standing up to their general partners.

They're so bad at it that a new white paper from the Kauffman Foundation blames investors for the poor long-term performance of venture funds. That's right. The reason venture capital doesn't beat public market performance, despite its high risk profile, is not the fault of the venture capital pros actually making the investment decisions.

It's the investors fault for supporting it. How depressing is that?

That's like if Third Point had told Scott Thompson and Yahoo it was Third Point's fault Yahoo's stock is in the gutter, instead of giving Thompson hell and eventually finding the evidence they need to get the man fired. Unlike most limited partners, Kauffman Foundation has decided to actually take a stand. The endowment is encouraging other institutional investors to do the same.

Consider this: Out of 100 funds that Kauffman Foundation has invested in over the last 20 years, 62 of them didn't beat returns on public markets after fees and carried interest. The hallowed J-curve, which says that 10-year venture funds typically lose money during their initial investment period and then produce healthy returns that increase over the back end of the fund, has not existed since 1997, the white paper reports.

Beyond that, venture funds are lasting longer and longer. In an environment keen to let your winners run, 10 years isn't the standard lifespan of a fund anymore. Extending a VC fund to 15 years makes it even harder for it to beat out public market performance.

There are a couple of things to keep in mind here. One, an institutional investor or endowment typically only allocates around 5 percent of its capital to venture. That's already a tiny portion; this white paper is advocating it go even smaller. Two, it's widely known that, after the top decile or perhaps quartile of funds, there's a huge drop off in performance. (And that's if you can agree on a definition of quartile and vintage year; most firms are adept enough to engineer the numbers such that their fund is "top something".) All of that is to say that, basically, LPs need to stop funding the losers. Of which there are very many.

Kauffman Foundation's self-blame is an attempt to change the conversation:

It’s so easy to point the finger of blame directly at VCs — there are too many of them, they’re raising too much cash, they’re sitting on too much cash, they’re investing too much cash, they’re taking home too much cash…

Rather than blame the VCs, who are just doing their jobs, why not blame the dumb money? After all, VCs are the drug dealers in this situation, and investors are the addicts. If everyone would just stop buying drugs, the dealers wouldn't have much of a business.

But that's easier said than done, for a number of reasons. One is that, as I mentioned, LPs are sort of wimps. At public pension funds, driving a hard bargain on things like terms and fee structures is (not always, but often) above the pay grade of the person making the allocation decisions. They are public employees, they don't get paid as much, turnover is higher, and experience doesn't run as deep.

There's also a fair amount of lore that clouds thinking when it comes to venture capital:

The historic narrative of VC investing is a compelling story filled with entrepreneurial heroes, spectacular returns, and life-changing companies. The quest to invest in the next Google guarantees that VC will retain its allure and glamour, even in the face of the disappointing results we’ve just discussed.

This is true, especially when headlines scream crap like Programmers Are the New Rock Stars, (or in this case, designers are).

What's more, VCs constantly talk about the home run/lottery ticket model of returning the entire fund on just one "hit" deal. But Kauffman Foundation's data shows that even mega-hits like Zynga or Facebook aren't enough to prop up returns across the industry.

So this white paper is a long way of one foundation saying "Man the F up" to its peers. Stop investing in anything but the top-10 firms managing top-performing funds. Stop accepting two and 20 as the industry standard terms (2 percent fees and 20 percent carried interest). Don't let your GPs raise increasingly large funds, since history shows larger funds perform worse. Don't imagine your "relationships" with underperforming VCs are anything but abusive. And if you don't have access to the top VCs, then simply don't invest in venture. Your money is better off in a small-cap index.

That's what Kauffman Foundation has done. The fund reduced its portfolio of venture funds from 100 down to around 30, thanks to secondary sales and attrition. And its not afraid to decline to re-up when VCs don't respect their requests on terms. If every fund with a venture allocation did that, it'd lead a lot more Walking Dead VC firms out there.

And it'd mean some entreprenuers might not find capital as easy to come by, with unsolicited term sheets and bubbly valuations. In fact, it just might fix everything that's messed up and irrational about tech financing. Investors may not be to blame for the broken VC model, but, considering they hold the purse strings, they certainly have the power to fix it.